Your friend Mark is quite worried about the recent volatility in equity markets due to the current health pandemic and is thinking about investing in the bond market. He contacts you to seek your advice on bond markets. You have undertaken some research and find the following information regarding yield on different bonds.

(i) 1.8% current one-year bond

(ii) 1.9% expected one-year bond rate in 24 months time

(iii) 1.93% three-year bond rate

REQUIRED:

1. Using the pure expectations theory advise your friend on the yield he should expect on a one-year bond in 12 months time.

2. Identify and explain to your friend two assumptions of the pure expectations theory that are challenged by the segmented markets approach to interest rate determination.

3. Your friend has heard that inflation is anticipated to rise significantly over the next few years. Explain to him what effect would this expected rise in inflation have on the slope of a normal yield curve? Also, what effect, if any, this change in inflation will have on the value of his bond investments?